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Tuesday, 15 September 2009

No-one is suggesting inflation-adjusting variable items during low inflation

It is correct, essential and compliant with IFRS to inflation-adjust or update or maintain constant real value non-monetary items by means of the CPI which is a general price index during all levels of inflation and deflation. The reason for this is that non-monetary items - both variable and constant real value non-monetary items - are expressed in terms of money, i.e. in terms of an unstable monetary unit of account which is the same as the unstable monetary medium of exchange. Inflation destroys the real value of the unstable monetary medium of exchange - which is also the unstable monetary unit of account in accounting and the economy in general. Constant items thus have to be updated or maintained or valued at a rate equal to the rate of inflation or deflation, i.e. valued in units of constant purchasing power, in order to maintain their real values constant during inflation and deflation respectively because the unstable unit of measure in accounting is an unstable monetary unit of account and consequently hardly every absolutely stable during periods of inflation and deflation.

Variable items do not need to be and are not valued in units of constant purchasing power during low inflation because they are valued in terms of SA GAAP or IFRS at, for example, fair value, market value, present value, recoverable value, net realizable value, etc which take inflation - amongst many other things - into account.

Variable items are only valued in units of constant purchasing power during hyperinflation as required by the IASB in IAS 29.

There is a school of thought that 2% inflation is completely unharmful and that it has no disadvantages compared to absolute price stability. This is not correct. 2% inflation will destroy 50% of all Retained Profits over 35 years – all else being equal – when the stable measuring unit assumption is implemented for an indefinite period of time during indefinite inflation. This is what is happening in the European Monetary Union and in the USA.

It is not correct for accountants to inflation-adjust by means of the CPI, which is a general price index, variable real value non-monetary items which are subject to product specific inflation or price increases (e.g. properties, shares, etc.) for the purpose of valuing these variable items during the accounting period on a primary valuation basis during non-hyperinflationary periods. These variable real value non-monetary items are generally subject to market based real value changes determined by supply and demand. They incorporate product or item specific price changes or product specific inflation where the word inflation is used to simply mean a product or product group price increase instead of the general use of the word in economics to mean the destruction of the real value of money over time, i.e. a general destruction of the purchasing power of money which results in an increase in the general price level over time.

1970-style Constant Purchasing Power (CPP) inflation accounting was a popular but failed attempt at inflation accounting at that time. It was a form of inflation accounting which tried unsuccessfully to make corporate accounts more informative when comparing current transactions with previous transactions by updating ALL non-monetary items (without distinguishing between variable and constant real value non-monetary items) equally by means of the Consumer Price Index during high and hyperinflation.

Measurement in units of constant purchasing power was used for variable AND constant items during the high inflation 1970´s. 1970-style CPP inflation accounting was abandoned as a failed and discredited inflation accounting model when general inflation decreased to low levels thereafter.
Summary: Balance sheet constant items have to be inflation-adjusted during low inflation exactly the same as salaries and wages because money is an unstable unit of account. Variable items are valued in terms of IFRS or SA GAAP. Product inflation is incorporated in the market prices and other measurement bases of variable items. Variable items are not inflation-adjusted during low inflation - only during hyperinflation as required by IAS 29.

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